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The Case for Cash

March 19, 2013 | About:

Josh Zachariah

36 followers
Being long cash is something few investors can champion, yet the very best do just that. Both Seth Klarman and Warren Buffett are known to carry large piles of cash relative to their investment portfolio. Surely both like to invest their money and Buffett himself acknowledges he’d rather put the cash to use, but if investable assets are not priced attractively then as these two investors will argue, it is best to sit patiently.

The need to be out of cash and invested in certain assets could not be more palpable. House prices and stock markets are appreciating and looming concerns of inflation ride high as gold and precious metals continue to hold their luster. Yet with the exception of the certain real estate markets, the underlying prices of many assets are not terribly enticing.

Howard Marks wrote an excellent piece crucifying bonds in favor of equities. For someone to invest in bonds they must feel very strongly about a deflationary environment as an increase in inflation decimates the return of a fixed-rate bond. Marks still cautions against equities even though he describes them as being much more attractive relative to bonds. To paraphrase some of his points, as stock market valuations rise much faster than underlying earnings then you must expect either a) continued high growth in earnings in the future or b) diminished future returns in stocks.

So why should you hold cash?

Cash has a couple benefits relative to other securities. Cash becomes more valuable when the markets go awry. For example, say inflation expectations suddenly change. Clearly the market expects inflation to remain subdued as rates in the bond market are still quite low. But suppose the economy gains steam and the investors expect a 5% inflation going forward. The bond market would likely convulse and bond prices would tumble. At that moment the dollars in your checking account would buy more in bonds even though they would buy fewer goods in the future should inflation actually poke its head. Bonds are inextricably linked to inflation and a rise in inflation drives the prices of bonds down.

Contrary to comments by Warren Buffett, there is a small penalty to not swinging in investing. The cash that sits un-invested will depreciate at the rate of inflation and currently it is doing so at 2%. But even if your money does depreciate at such manageable amounts you can still count on stock market volatility in the future. If history is a guide there will be plenty more opportunities to buy stocks when prices are undeniably cheap.

I wouldn’t advocate holding your whole portfolio in cash, but having cash on hand is certainly a good thing. In Alice Schroeder’s biography of Warren Buffett she describes his attitude towards cash: “This is one of the most important things I learned from him: the optionality of cash. He thinks of cash as a call option with no expiration date, an option on every asset class, with no strike price. It is a pretty fundamental insight. Because once an investor looks at cash as an option – in essence, the price of being able to scoop up a bargain when it becomes available – it is less tempting to be bothered by the fact that in the short term, it earns almost nothing.”

If stocks and other investments continue to grow pricier relative to earnings, then it would be wise to hold increasing amounts of cash. It’s at these moments when cash becomes the contrarian investment. Howard Marks wrote in his article that the stock market’s current P/E ratio of 16 is at the historical average for post-World War II (very interesting he decided to leave out the '30s, as that would certainly bring the average down). In any case, being that we are dealing with averages, we can expect some below-average P/E ratios sometime in the future.

About the author:

Josh Zachariah
I credit my father and Warren Buffett for molding me into the investor I am today.

Rating: 3.6/5 (16 votes)

Comments

kfh227
Kfh227 premium member - 1 year ago
Buffett has alot of cash because he never wants to have to borrow to settle claims on the insurance arm of Berkshire.

Josh Zachariah
Josh Zachariah premium member - 1 year ago
That is true, he does have to hold a lot of cash for the reinsurance operation. But he does tend to find himself with larger amounts of cash when the equity markets are not cheap. You didn't hear him complaining about his 'trigger hand' being itchy in 2009. He was firing away buying stocks and buying what was at the time high yield and usually convertible debt.
ansgarjohn
Ansgarjohn - 1 year ago
Seth Klarman: "...why should the immediate opportunity set be the only one considered, when tomorrow’s may well be considerably more fertile than today’s. "_[www.grahamanddoddsville.net]
Dr. Paul Price
Dr. Paul Price premium member - 1 year ago


Anyone who believes true inflation is the 2% reported by the BLS shouldn't be given any credibility.
jonmonsea
Jonmonsea premium member - 1 year ago
I think there is a distinction to be made between not swinging and not investing. Buffett is talking anout the former not the latter as your article states. So, holding cash IS investing but is NOT swinging per Buffett. The meaning? One can lose 2 % to inflation for 5 years and then invest in something, say a stock, that is 30% undervalued and growing at 3% a year. Ten years on, one has made more money than if one had bout an index fund in year one out of fear of inflation.
swnyc2
Swnyc2 - 1 year ago
For those who wish to read a nice, recent article about the accuracy of the government reported inflation rate click here:

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